The 16 safe dividends

We’ve tried to build this thinking into a simple filter that looks at the FTSE 100 universe and then systematically excluded any company that doesn't fit the following criteria.

1. We looked at the more recent past – the last eight years – and excluded any company that hasn’t increased its dividend year on year over those eight years.

2. We examined forward projections of dividend growth by analysts and only included those companies where dividends are set to increase. As always, though, bear in mind that these are estimates and the analysts could have got it wrong.

3. We've only included companies where there is a stated dividend policy. This will usually consist of a simple commitment to growing real sterling dividends (Pennon, for example, is committed to growing dividends at 3 per cent a year), or a commitment to paying a fixed percentage of earnings (30 per cent in the case of ICAP, for example).

4. Only companies with a proper dividend reinvestment plan have been included – see the box on page 32 to see how these operate.

The resulting shortlist comprises just 16 companies in the FTSE 100 and their details are in the Dividend Heroes table on page 32 alongside some other key measures, such as:

■ The potential foreign-exchange risk – how much of the business is conducted outside of the UK? If a large portion of turnover is derived in dollars and euros this opens the company up to some risk if the exchange rate goes against them (although the opposite has been happening in the past six months). Most companies will aggressively hedge away this exposure but it's estimated that up to 60 per cent of the entire earnings of the FTSE 100 is based on foreign earnings.

■ We’ve included a measure for cash flow per share in the most recent accounts – this shows you how much the dividend per share is covered by operating cash inflows. As long as it's above one, the company can afford the payment, and anything above two is reasonably safe.

■ We've also noted any pensions scheme liability, where disclosed. The pensions regulator has already warned that it expects companies to sacrifice their dividends before they cut pension payments, so a company with a high deficit is potentially risky. None of our shortlisted companies is in too much trouble.

■ Last, but by no means least, we've included the level of borrowing – this could be an indicator of future trouble if SocGen's analysis is correct. But it's worth cautioning that many utilities have high levels of regulated debt that are comfortably backed by both real assets and growing earnings.

We're deliberately not going to make any comment on the attractiveness of any company in the shortlist below – the point of this exercise is not to suggest whether the market thinks the stock is a buy or not. The point is that every one of these companies has been consistently growing their dividends and that consistency (if they keep it up) has real value.

In regard to returns, it's worth stating one simple fact: over the eight-year time frame that we've used, the FTSE All-Share index has declined by just over 11 per cent in total returns terms (dividends included) – yet the companies in our list have returned an average of 30 per cent in total. But that average total return increases to an impressive 61 per cent if you reinvested the dividends.

Caveats

The job of the dividend hunter is a rather tricky one. They're assaulted by a huge range of problems and challenges, not least the decision of many companies to stop paying dividends. So we can make no assurances that the companies we have picked will keep on paying their dividends in these difficult times – they should do, if their past behaviour is anything to go by, but they might choose to play safe and cut dividends.

The truth is that across the markets as a whole dividends are falling fast. Rob Davies at the Munro Fund – a dividend-weighted passive index-tracking unit trust – tracks the total current estimated dividend payout for the FTSE and it has made for scary reading over the past few months.

The markets expect dividends to remain under intense pressure. According to research by ING Wholesale Banking, of the 59 large-cap European stocks that have declared dividends so far this year, nearly half have either cut their dividends or omitted them entirely. This has caused huge jitters in the financial markets – and especially in a niche market that trades swap financial instruments that track the estimated dividend payout in 2009. The swaps dividend market is pricing in a 31 per cent drop in European dividends from 2008 to 2009, and then a 48 per cent drop from 2009 to 2010. In effect, the swaps market is saying that no bank, no insurance and no auto company will pay dividends, alongside a 38 per cent cut in all other sectors. Many contrarian analysts, including those at SocGen, suggest that while the economy is bad, it's not quite that bad, and therefore dividends should start growing again next year at the very latest.

Caution required

It's not just falling or vanishing dividend payouts that you need to be wary about, though – you also need to be incredibly careful about an undue concentration on just a few big companies, nearly all of which earn most of their profits in foreign currencies, with more than a few focused on oil. According to research from Citibank, just seven companies contribute half of the total UK dividend base. Their analysis suggests that of the total dividend base 37 per cent is paid in dollars, while 25 per cent is from the oil sector. Citibank's bottom line: "A sharp fall in the oil price below $40 a barrel would make the sustainability of the dividends questionable."

And, as for a quick and sudden strengthening in the sterling rate against the dollar, the consequences could be cataclysmic. GlaxoSmithKline noted in its annual report last year that every 10¢ movement in the cable rate (sterling versus dollar) has a direct 3.5 per cent affect on earnings, even after their extensive hedging operations. With just £620m of its £19bn sales made in the UK, you can understand that caution – a run on the dollar that pushed cable back to $2 would directly hit EPS by between 15 and 20 per cent, with possible knock-on effects on the dividend.

British dividend aristocrats